Option Spreads: Selling And Buying To Form A Spread
Published orginally at Investopedia.com
By John Summa, CTA, PhD, Founder of OptionsNerd.com
When you buy or sell a call or a put option, you are using only one option strike and, by definition, trading in a single contract month, with one expiration date and always only one underlying. The Greeks apply to that one option only. However, depending on the type of spread trade you might use, you may be incorporating not just different strikes, but multiple months and, in some cases (when trading futures options), multiple underlying contracts.
But before we get ahead of ourselves, let’s start by thinking in terms of a basic spread and what that means.
If we were to reduce the idea of a spread to its most basic or essential characteristic, it would have to be its use of two option contracts, known as the “legs” of the spread. Using two legs simply means that you are combining, for example, a call option that you buy (sell) with a call option that you sell (buy). Therefore, you are taking both sides of the market in all spreads (buying/selling or selling/buying). That is the easy part.
While the spread is a simple concept, it can become a bit more difficult in practice – especially in terms of the implications for profit/loss given a directional move of the underlying. Many traders are less likely to consider risk dimensions measured by Theta and Vega, but that doesn’t make them any less important. These Greeks, shown in Figure 1, are important measures of risk, so let’s take a moment to review them. (For further insight, see Getting To Know The “Greeks”)
Delta is a measure of exposure to price changes, Vega is a measure of exposure to volatility changes and Theta is a measure of exposure to time value decay. (For more on this, see The Importance Of Time Value.) Looked at in terms of a spread with two legs, these risk measures refer to the entire position (i.e. “position Delta”, “position Theta”, “position Vega”). The position Greeks will be explained further below, as we examine each type of spread discussed in this tutorial.
Since a spread trade always involves the use of more than one option strike price, let’s examine what this means in terms of the Greeks. Remember that when you buy a call, for example, you are exposing yourself to the risk of a wrong-way move of the underlying (i.e. you don’t want the stock to fall). Or perhaps you face risk from a too-slow rise of the underlying and potential loss from time value decay (i.e. you want a bullish move of the underlying and you want it as quickly as possible).
But when you construct a spread, which involves both selling and buying options as two sides or legs of the spread, you are taking the other side of the trade in the underlying. This fundamentally changes the risk you face. Now, since you have sold a call and bought a call (for example), you have less risk from a fall in the market and from decay of the premium (since the call you sold will profit from both these developments), instead of facing the risk of a wrong-way move as mentioned above when in a long call, or a market that moves too slowly in your intended direction.
In other words, the purchase of the call in question, given a bullish outlook, is subsidized by the sale of a further out-of-the-money (FOTM) call (the time premium collected offsets the purchase price of the call purchased). While limiting risk (we will come back to this below with an example), it also limits exposure to time value decay (the short call gains with passage of time) and downside price movement (the short call gains here, too).
You might be wondering how you can profit from a spread if you buy and sell a call (or put) that both gains and loses with not just wrong-way moves or no movement, but also with the correct move in the correct time frame. The answer can be found by looking at the different strikes chosen and the resulting differential position Theta, Delta and Vega resulting from any particular spread construction. The word “differential” is a fancy way of describing the net Theta, Delta or Vega values (what we have after combining the individual Greek values on each leg) of the spread. If you are confused, the examples below will help to make this somewhat abstract discussion more concrete.
Remember that with an outright option you have a measure of Theta, Delta and Vega (among other risk measures known as the “Greeks”). When you construct a spread using different option strikes, you in effect are combining the Delta, Vega and Theta of each strike into one trade, giving you a position Greek. For example, when you combine the two Delta values of each option in a spread, you now have a net Delta, or position Delta, which can be negative (net short the market) or positive (net long the market). This is true for Vega and Theta, as well as the other Greeks, but the implications of the signs on the values are different, as we will discuss later. (For more insight, see Going Beyond Simple Delta: Understanding Position Delta.)
Before looking at the most commonly used spreads using call and put options, let’s take a closer look at our idea of position Greeks and explore what this means in terms of the risk/reward story.
Go to Part 3: Vertical Options Spreads